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Bubbles Part III

By: Jim Mosquera | Wednesday, April 16, 2014

In the previous
article, I provided a brief outline of the South Sea Bubble
of 1711-1720. In this article, I focus on the current financial bubble and
its aftermath.

A bubble's anatomy consists of three main areas: creation, collapse, and aftermath.

Creation

A favorable public psychology - confidence.

A herding instinct.

The means to speculate with money or credit.

Collapse

An investor (just one) willing to sell at a lower price.

The default on loans and evaporation of new credit.

Discovery of massive fraud.

Aftermath

Collapsing prices.

Recriminations of "guilty" parties.

Government attempts to restore public confidence.

I consistently use 1981-1982 as a starting point for the start of our financial
bubble. There are demographic and generational forces that served as catalysts.
I could write a significant amount on those two topics. Public confidence increased
during the 1990s and after a brief dip from 2000-2002, the bubble collapsed
in 2007-2008. Investors systematically piled into stocks and real estate not
wanting to miss the next sure thing (herding instinct). The means
to speculate was made possible through the greatest credit binge in
history by private investors and government entities. Rather than label this
a stock or real estate bubble, we can really just say it is a financial asset
bubble.

Prices in the stock and real estate market started their cascade down when
some investors sold at lower prices. Commodity prices collapsed.
When these markets broke, we heard officials saying the credit markets "seized
up" (aka, the evaporation of new credit). The FBI uncovered
dozens of high-profile Ponzi schemes, the Bernard Madoff scheme being the largest.
The Ponzi schemes satisfied the massive fraud criteria.

Our aftermath included a continuing collapse of prices. A severe
public backlash erupted against leaders of banks, hedge funds, and former market
wizards (recriminations of guilty parties). The US government
embarked on a spending spree of mythical proportions. Our Congress, with Executive
Branch prodding, took legislative measures (Dodd-Frank among them) to combat
future bubbles. The Federal Reserve embarked on a formerly incomprehensible
spending spree that added trillions to their balance sheet. The euphemism,
Quantitative Easing, became part of our financial lexicon. All of these measures
satisfy the criteria of government attempts to restore public confidence.
[Note: the Fed would not qualify as "government" though their intent of restoring
confidence applies]

The problem with our contemporary bubble is its sheer size. Our bubble is
a product of unabated confidence (read credit expansion and debt accumulation).
It was very difficult for the public to recognize the effects of this bubble
since there was no pain felt in its creation. Our political leaders only exacerbated
its effects through devastating increases in public debt. Using 1980 as a base
year, the outstanding public debt of the United States in its previous 200-year
history was $909 Billion. This included debt-creating events such as The Revolutionary
War, The War of 1812, The Civil War, The Spanish-American War, World War I,
World War II, the Korean War and the Vietnam War. Throw in government efforts
to fight the Great Depression of the 1930s, and we have readily identifiable
reasons for public debt increases.

After 1980, our public debt tripled to $2.6 trillion by 1988. By 1992, this
debt surged to $4 trillion. It took 8 years to reach $5.6 trillion in 2000.
By 2007, the top of the bubble, the debt reached $8.7 trillion. As I write
this our debt is $17.5 trillion.
For those scoring at home, our debt exceeds our GDP by over $1 trillion.

The anatomy of this bubble fits the prerequisites noted earlier. What is most
disturbing is not that it meets all the characteristics of a bubble but the
sheer magnitude will make the bubble pop feel more like the aftermath of a
10-megaton nuclear blast. You might argue that the bubble popped in 2008 and
to a large extent it did. However, governments have coordinated their efforts
to employ Keynesian economic stimulus and central bank tinkering to reflate
the bubble. So while individuals and businesses recognized the bubble pop and
made some economic adjustments, the financial Wizards had other ideas.

Government and central banks are not above the market. They are participants
consuming resources, borrowing money, and allocating capital. Governments and
central banks do not operate in an orbit around the earth sprinkling magic
dust on economic problems. This is the mother of all bubbles and she is still
in the house.